1. Field of the Invention
The present invention is directed to financial services and more particularly to an electronic and financial method and system for initial offerings of multi-class securities or other financial instruments. The present invention is also directed to a method of reducing or even eliminating risk to investors in multi-class instruments.
2. Background of the Invention
Part of the financial innovation in the 1980s was the development of multi-class debt instruments with embedded options. An embedded option is an option that is attached to the security. The embedded option may, for example, impact the principal payment, interest payment or both. Typically, these debt instruments are collateralized with U.S. government securities, agency securities or agency-guaranteed pass through mortgages, i.e., a collateral pool. The cashflow from this collateral pool is allocated to the different classes of the multi-class instrument according to a predetermined formula specified in a trust indenture document associated with the multi-class instrument. A multi-class instrument can be either an actual security (as defined by the Securities and Exchange Act of 1934) or a notional swap transaction.
The face value of a transaction refers to the amount of principal that an investor pays up front when the transaction is initiated. Over the life of the instrument, the investor will receive back the principal amount that was paid up front. For example, if an investor buys $100 MM face value of Treasury notes, the investor will receive $100 MM in principal at the maturity of the notes. The interest component of the investment is linked to the face value. If the coupon rate is 10% and the face value is $10 MM, the interest payment will be $1 MM ($10 MM*10%=$1 MM).
The market value of the transaction is simply the price of the instrument multiplied by the face value. The price of an instrument is often expressed in percentage terms. A price of 103 actually means 103%. An instrument with a face value of $10,000,000 and a price of 105% will have a market value of $10,500,000. An investor who pays 105% for an investment with a face value of $10,000,000 must pay $10,500,000 to initiate the deal. But the investor will only receive $10,000,000 in principal back—not $10,500,000. All interest payments are tied to the face value of $10,000,000.
In a notional value transaction no principal is exchanged. The notional value simply serves as a computational tool to compute market value and interest payments. If an instrument has a notional value of $10,000,000 and a market price of 105%, the investor would only pay $500,000 to initiate the transaction. If the notional transaction had a coupon rate of 10%, the instrument would pay $1,000,000 in interest.
A multi-class structure can include all notional instruments, all face value instruments, or any combination of the two.
Examples of multi-class instruments include Collateralized Mortgage Obligations (CMOs), Collateralized Bond Obligations (CBOs), Collateralized Loan Obligations (CLOs), Stripped Mortgage Backed Securities (SMBS) and a broad variety of structured notes such as Indexed Currency Option Notes (ICONs), BISTRO (Broad Indexed Structured Trust Offering), Indexed Amortizing Notes (IANs), range floaters, and credit linked notes.
Such instruments serve an important function in capital markets in that they allow a convenient mechanism for investors to literally buy and sell financial risks such as interest rate risk, credit risk, mortgage prepayment risk, currency risk, or credit default risk.
Additionally, these instruments allow investors to benefit from future market conditions such as the level of interest rates, the shape of the yield curve, the spread between U.S. government rates and other corporate rates, currency exchange rates, mortgage prepayment rates, credit default rates or the value of another asset (e.g., gold price, oil price, or stock price).
The various classes (often called “tranches”) of a multi-class security need not be the same size. Indeed, the sizes of the classes can vary significantly. Generally, the only restriction is that the sum total of the cashflow to all of the classes equals the total cashflow generated by the underlying collateral.
FIG. 1 illustrates a typical multi-class instrument known as a collateralized mortgage obligation (CMO) based on Federal National Mortgage Association (FNMA) collateral. In this case, a pool of FNMA collateral worth nine million dollars and having an average life of ten years is offered in two separate classes. The first class (Class 1 in FIG. 1) is a planned amortization class having a face value of one million dollars and an average life of four years. Class 2, on the other hand, is a support bond having a face value of eight million dollars and having an average life of eighteen years. Note that the face values of the two classes do not include an underwriter's profit or administration costs, issues that are addressed later herein.
It is often the case that the cashflow allocation structure of a multi-class instrument is such that under certain market environments, an investor stands to make a substantial return while under alternative market environments, the investor could face significant losses. For example, assume Class A of a multi-class instrument provides for interest of 1% if the yield on the five-year Treasury is 6% or lower. If, on the other hand, the yield on the five-year Treasury is greater than 6%, the interest rate on Class A would jump to 9%.
Investors cannot ordinarily obtain such financial positions through direct investments in the underlying collateral. For example, no direct investment in any Treasury instrument would provide a payoff of 9% under some set of circumstances and a payoff of 1% under another set of circumstances.
Instruments with such asymmetric payoffs appeal to two types of investors: speculators and hedgers. A speculative investor usually has a strong view about future market conditions and wants investments that will generate substantial returns should those conditions materialize. A hedger, in contrast, has concerns about the impact of adverse market conditions on other existing investments or future business operations. For example, if interest rates rise dramatically, an investor might lose significantly on current investments.
In the multi-class instrument example described immediately above, a speculator who felt confident that the five-year Treasury would yield over 6% would want to purchase Class A. An investor who would be hurt financially if the yield on five-year Treasury securities went over 6%, might consider the purchase of Class A as a hedge.
In addition to asymmetric payoffs, investments in certain classes of multi-class instruments are perceived to be less risky than investments in the actual underlying instrument.
For example, in a CMO (like that illustrated in FIG. 1), the cashflow from an underlying portfolio of traditional mortgages is allocated such that some classes receive greater protection against mortgage prepayment risk than a direct investment in the traditional mortgage security. Other classes are more exposed to prepayment risk. The classes with lower prepayment risk carry a lower yield while classes with greater prepayment risk carry a higher yield. Investors seeking lower prepayment risk cannot obtain such a position through a direct investment in the underlying mortgage collateral. Similarly, investors with an appetite for greater prepayment risk cannot obtain such a risk profile through direct investments in traditional mortgages.
In a CBO, the cashflow from an underlying portfolio of corporate bonds is allocated such that some classes receive greater protection against issuer default than a direct investment in the portfolio of corporate bonds. Other classes have greater exposure to borrower defaults. The classes with less default risk carry a lower yield. The classes with the greater default risk carry a higher yield. Direct investments in the underlying collateral of corporate bonds cannot produce these desired exposures.
In the CBO and the CMO, the structure of the entire multi-class instrument is transparent and readily observable to all potential investors. The trust indenture documents clearly list all the classes of the structure and their right to the cashflow allocation. A multi-class instrument need not directly list or disclose all the classes, however.
A note with an embedded option is an example of a structure where the multi-class nature of the structure is hidden. An Indexed Currency Option Note (ICON) is a note where the final principal returned at maturity is linked to a foreign exchange rate. An ICON linked to the dollar/yen rate, for example, would pay a regular stated coupon. At maturity, the investor would receive a principal amount tied to the dollar/yen exchange rate on the maturity date. The principal redemption formula might be a formula such as: 100% return of principal if dollar/yen is above 150; otherwise receive Exchange_Rate/150 of principal. If dollar/yen exchange reaches 110, the return of principal would be 110/150 or 73.33% of principal.
The investor in this note only sees the interest payment and principal redemption schedule. In this case, this schedule only shows the amount of interest and principal due to the single Class. No mention is made of what happens to the principal that is not returned to the investor. In fact, the ICON structure consists, typically, of a traditional bond (usually a Treasury or federal agency note) and option position on exchange rates. The buyer of an ICON has sold an option on exchange rates. The underwriter has usually made alternative arrangements to find a buyer for the option sold by the ICON investor. The underwriter may even purchase the option to hedge internal proprietary positions.
Note that there is no actual investment in Japanese Yen currency or Japanese Yen denominated investments. The return is indexed (i.e., linked) to the Japanese Yen exchange rate. Multi-class instruments will often allocate cash flow to the underlying classes based on the value of some external index such as a foreign exchange rate, change in the value of an equity index (e.g., S&P 500), prepayment speeds on a mortgage pool, or the price level of a commodity (gold, oil).
The presence of the underlying collateral (the Treasury or federal agency note) removes any concern regarding performance risk. Neither the investor in the ICON nor the buyer of the foreign exchange rate option need worry that they will not receive the promised cashflow. The cashflow rules are set such that the collateral will always generate the promised cashflow in all but the most extraordinary circumstances (e.g., failure of the United States Government to honor its debt obligations).
The underlying collateral in the ICON is usually placed in an irrevocable trust with a well established fiduciary hired to implement the cashflow allocation rules. This embedded performance guarantee of these multi-class securities effectively avoids the need for margining as is common with transactions in “exchange traded options” instruments. The lack of margining also often leads to more favorable accounting treatment for certain investors in certain cases.
In all the examples of multi-class instruments discussed above, a critical consideration is that if an underwriter undertakes to sell one class, the underwriter must also sell all other classes for the transaction to be profitable. For example, in the case of the ICON, the underwriter must find a buyer for the ICON and the foreign exchange option. This concept is discussed in detail below.
Underwriter Role and Economics
The objective of the underwriter is to structure the various classes of a multi-class instrument so that the total market value obtained from selling each class exceeds the cost of purchasing the securities and administrative costs of establishing and administering the trust. For example, assume that the total cost of the underlying collateral of the multi-class instrument is $100 million and the cost of establishing and administering the trust is $1 million. The effective cost to the underwriter is therefore $101 million. Now, assume that the underwriter creates a multi-class security with three classes: the underwriter might price Class 1 at $51 million, Class 2 at $30 million and Class 3 at $21 million. If successful in placing all the classes, the offering will generate $102 million (51+30+21) in revenues and, therefore, $1 million in potential profits.
In accordance with prior art financial methods, the underwriter must first purchase the collateral and then attempt to sell the different classes. Significantly, if the transaction is to be successful, the underwriter must be able to sell all of the classes at the target price. However, the underwriter is susceptible to several risk factors before all of the classes are sold.
For example, there might be no demand for one or more classes at the underwriter's target price. In this case, the underwriter must lower the price on the unsold classes. This reduction could reduce or eliminate any profit from the transaction. In the above example, if the underwriter is forced to sell Class 3 at $17 million (instead of $21 million), the underwriter win net only $98 million from the sale of all of the classes. Accordingly, the underwriter will lose nearly $3 million on the transaction. The lack of demand may have various causes. One common reason is that even though the underlying collateral (e.g., mortgages on houses, condominiums, etc., in the case of a CMO) might be considered low risk, the prepayment schedules on the mortgages are sometimes very unpredictable. This unpredictability tends to make subordinate classes of a multi-class instrument less attractive to investors.
Further, the underwriter may not be able to sell the classes at any reasonable price and therefore must hold on to the classes for an indefinite period of time. During this period, the underwriter is subject to potentially large financial risks inherent in these classes such as prepayment risk, interest rate risk, price risk or credit default risk. Consider an example of a two class instrument. Class 1 receives 120% return of principal if the dollar-to-yen exchange rate is above 110. Class 2 only receives an 80% return in that case. If the underwriter is unable to sell Class 2, the underwriter bears the full risk of paying the Class 1 investor the extra 20% return.
The underwriter is also subject to market risk between the time the collateral is purchased and the time the classes are sold. For example, changes in the market level of interest rates can cause a dramatic fall in the value of the collateral. The underwriter bears this loss. Consider what happens in the above example where the underwriter purchases the collateral for $100 million. Market conditions change and the value of the collateral falls to $95 million. The underwriter had planned to sell the individual pieces for $102 million, or a 2% premium over the current market price. The current market price is now $95 million. Even if the underwriter can earn the 2% premium, the underwriter will net only $96.9 million and will, therefore, realize a loss of nearly $3.1 million on the transaction.
While sophisticated hedging techniques involving financial futures, options, and other instruments can reduce the underwriter's exposure to market moves, these techniques involve additional costs and carry additional management and administrative burdens. Moreover, improper hedging techniques can actually increase the potential for losses.
In view of these risk factors, only well capitalized underwriters with large distribution networks have heretofore taken part in offering multi-class instruments. That is, only a firm with significant capital can afford to hold onto a position if buyers for all classes can not be found. And, only a firm with a large distribution network has the resources to find buyers for all classes. However, the extensive capital and large network of such firms only serve as a cushion against the risks of these transactions; the risks are not eliminated.
In recent years, electronic trading systems have been developed for many financial products. Investors can purchase equities, bonds, money market instruments, derivative instruments, futures, options, and various commodities over private electronic networks and over public electronic networks such as the Internet. Both buyers and seller can post their transaction price on these systems and clear the transactions. However, all of these systems only handle single class instruments where a seller of, for example, 100 shares of stock does not also incur a concurrent obligation to sell additional shares of other stock.
There has also been a lack of attention given to improving the demand for multi-class instruments and, particularly, the more subordinate classes thereof.